Join The Motley Fool's Brendan Byrnes for a conversation with David S. Rose, serial entrepreneur, super-angel investor, and author of Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups. An Inc. 500 CEO, Rose is founder and CEO of Gust -- a global platform that allows entrepreneurs to collaborate with investors through all aspects of the investment relationship -- as well as founder and chairman emeritus of the leading angel investment group, New York Angels.

For this interview Rose sits down with The Motley Fool to discuss the basics of angel investing, what makes it so risky, and how rewarding it can be when done correctly. He also explains what it means from the start-up's point of view, and what sort of angel investors an entrepreneur should seek out.

Brendan Byrnes: Hey, folks, I'm Brendan Byrnes and I'm joined today by David S. Rose. David wears many hats. He is a serial entrepreneur, the CEO and founder of Gust. He is also the author of the new book, Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups. Thanks for sitting down with us today. It's great to spend some time with you.

David S. Rose: My pleasure.

Byrnes: I wondered if you could first start with just what is angel investing, and what kind of investors can be angel investors? I know you probably recommend they're accredited investors, right?

Rose: It's not a question of recommending; they have to be, according to the law!

Angel investors are people who fund early stage companies. The difference between angel investors and venture capitalists or banks is really important. Banks lend money, and they want it back after they give it to you -- after a year -- with rent, or interest on that money.

Venture capitalists are professional money managers who raise a big pot of money from institutions like insurance companies or pension funds and the like, and invest it in companies to get a big return.

But angel investors are individual people who take money out of their own pockets and put it in these start-up companies, often earlier and in smaller amounts, than venture capitalists. But, unlike banks, they don't just want their money back with interest. They want a piece of the growth potential of the company.

Angels are individual people who invest their own money into early stage companies, when it's very, very risky, looking for a very large return.

Byrnes: You mention it's very risky. What's a normal batting average for angel investors?

Rose: If you look at the good companies, and you do a really decent job at getting rid of the companies that shouldn't be invested in, and you only invest in the best ones, half of them are going to fail -- literally half -- so it's a very risky business, and that's what this book is all about. The book is about how to be a professional angel.

The difference here, unlike the casual angel who says, "Oh, that's a cool company and I'll just throw some money at it," if you do it long term with a view to having at least 20 or 30 or more companies in your portfolio, yeah, half of them are going to fail.

But you know that going in, because no matter how well you pick them, how good the entrepreneur is, how great the market, things happen and half will fail. But of the half that don't fail, you might get your money back on a couple. You might make a decent profit -- two or three times your money -- on another two, but one out of those 10 hopefully is going to return 20, 30, 40 times your money and, at the end of the day, that makes the whole portfolio work.

Byrnes: If they need 20-30 companies, as you recommend, how do you find these companies if you're an angel investor? Is there a good way to network and find them? What's the best way to do that?

Rose: It used to be almost impossible, because it was like an entrepreneur and an investor running around on a dark football field in the middle of the night, wearing sunglasses, saying, "Hello? Hello? Anybody here?"

Now, the world has changed quite a bit for a number of reasons. First of all, it's a lot cheaper to start a company, so there are a lot more of them. Second of all, there are a lot more venues, ranging from accelerator demo days to pitch competitions and stuff, where you can go and see companies.

Third of all, the SEC changed their rules because of the Jobs Act last year, so now companies can do what's called "generally solicit," which means they can say, "Hey, I'm raising money." Until September 13 of last year, a company that was raising money couldn't tell anybody it was raising money, which was very challenging to let you find them. But now they can.

Now there are an increasing number of angel investment groups, like New York Angels which I founded here in the city, which sees literally thousands of applications for funding every year.

Then of course there are online platforms like Gust, which has hundreds of thousands of companies, because companies use it to manage their investor relations and find investors -- so if you're an investor, you can come onto a thing like Gust and see literally hundreds of thousands of companies.

Byrnes: Why should an accredited investor be an angel investor and not just invest in a VC fund?

Rose: Well, an accredited investor is somebody -- for our audience -- who has an income of over $200,000 a year, or assets of over $1 million a year, not including their primary residence. They should not put all of their investments into angel investing! It is very risky, very high-risk, but very high-reward if you do it right.

Therefore, the suggestion among most people who are familiar with the field, is that you should allocate no more than 10% or so of your portfolio to angel investing. But this is a decent part of the alternative asset class, so you may have most of your stuff into stocks and bonds, depending on your risk profile, but if you have a little bit here in this angel world, the returns from a solid angel portfolio, done correctly over time, can be over 25% annually.

Now, 25% IRR, compared to 1% from a bank, or 5% from the market, or 10% maybe from a hedge fund... 25%, even for 10% of your portfolio, makes the whole rest of your portfolio a pretty good thing.

Byrnes: Absolutely. You mentioned "doing it correctly," getting 25%. How do you do it right? Do you think angel investors should stick to their areas of expertise? Maybe if they've been working in tech, should they focus mostly on tech start-ups? How do you think they properly do this, in order to hit that 25% return?

Rose: That's actually why I wrote the book! The whole book is how to do it professionally, and it's really from beginning to end. One, it's doing things like investing in what you know. I don't invest, for example, in biotech opportunities because I know nothing about biotech.

Last week, I was helping train the people in the Council of Fashion Designers of America Accelerator. They have some wonderful start-up fashion teams in there, and while I can be very helpful in terms of how to do a presentation and how to structure a deal, when I was looking at these fashion deals, I don't have a clue. You'd have to be an idiot to have me investing on a fashion deal, because I know nothing about fashion!

On the other hand, I know a lot about tech, so that's an area where I do invest. So, yes, invest in an area you know. But, more than that, don't be caught up by all the nice shiny, bright things you see. Really do your due diligence and understand the financials of the company.

You have to have a large number of companies that you see coming in, so we have to cultivate what we call the top of the funnel -- all the companies that you have access to, through people you know, connections, people in your portfolio, going to demo days and pitch competitions -- and then you have to be pretty ruthless about cutting them down.

Angels typically invest in only two or three percent of the companies that they see, so that's one out of 40 companies. You've got to be really tough. Then, having picked a company to invest in, you have to make sure that the valuation is correct, because if you're trying to get 20 or 30 times... 20 or 30 times on a $10 million valuation is $200 or $300 million; 20 or 30 times on a $1 million valuation is $20 or $30 million, which is a lot more achievable as an exit.

So, you've got to structure and value it right, and then you want to try and add value to the company and be helpful.

Byrnes: How do you valuate that right? It would strike me as not an exact science here, where a lot of these companies aren't making any money, so you look at different ways to valuate them.

Like a WhatsApp, for example -- not making much money but they have a tremendous amount of users and user growth, etc. Do you just have to look at different metrics like that, or is it more the idea, the founders...?

Rose: We call it "betting the jockey, not the horse." You're always betting on the founder -- that's the first and most important thing.

Byrnes: The founder is more important than the idea.

Rose: The founder is more important than the idea, yes. Because ideas are really a multiplier of execution, and how the founder executes on that idea is really critical, so we will almost always take a world-class founder with a moderate business plan, as opposed to a great business plan but with a founder who can't execute.

But if you're going to be interested in angel investing, you have to realize this is not typical market investing, so metrics don't apply in the sense that people think they do. You can't analyze past performance, you can't look at all their guidance for the year and say, "This is where things are going."

It really is a combination of art and science and experience and the market. You're looking at this, you're trying to get a feel for, "Is this company in a large and growing market?" A good market lifts all boats.

Does this company have what it takes in terms of the management team and the entrepreneur? Does the business model make sense? Is it scalable so it can start small and then get larger? You factor all of these things together.

There are about half a dozen different ways to value companies, and I go through them in the book. There's the venture capital method, there's the Dave Berkus method, there are methods where you go through each of the various areas of the company's management team and IP protection and so on and so forth, and then compare it against the industry.

It's not metrics per se, but it's an overall valuation heuristic.

Byrnes: Let's flip this around and look at it from the start-up's point of view. Why would a start-up want to invest in an angel investor? Should they look for someone that has expertise in that area? Should they look for someone that's going to be supportive, get them more resources? What should they look for?

Rose: The first question, as to why they would look for an angel investor, is because where else are they going to get the money? The bottom line is, banks do not lend money to start-ups, period.

And venture capital funds typically don't invest money in start-ups. They invest in the later stage. People think that VCs are funding all these start-up companies, but that's really what you see in Silicon Valley on television, and read in the blogs.

In the real world, VCs invest $20 billion a year, but it's almost entirely in later-stage companies. There are only about 1,000 companies or so every year, out of the 700,000 who get started, that VCs invest in.

In contrast, angels invest in something like 50,000 companies a year. So, if you are looking for early stage start-up funding, the first cash is going to come from you, as the founder -- because if you don't put your own cash in, nobody else is going to invest.

Then typically, the next money comes from your friends and family. It doesn't have to, but that's where it usually comes from because they're investing in you as a person, not in the business. Then the next step, because you're not going to get it from the bank and you're not going to get it from a VC, is angel investors -- so that's why you go to an angel.

As to who you look for, you want to look for smart money. I will always take smart money over dumb money! Dumb money is somebody with a big checkbook who will write you, "Oh, sure, what do you need? You're going to make a trillion dollars next year? Great, here's a $100,000 check."

Although it seems easy, and it seems fun, and it seems like you're going to get a higher valuation and less dilution and so on, in the long run smart money -- people who have done this successfully and can really add value -- are the way to go.

Byrnes: Tell us a little bit more about Gust, and how that works, and how you got involved with that.

Rose: Sure. Gust is the company that I started a number of years ago, to be the infrastructure platform for this whole early stage financing industry. Gust is the platform that powers about 90% of all the organized angel investment groups in the U.S. -- and probably 70% of all the angel groups in the world, for that matter.

Companies, on the one hand, use Gust to create an investor relations website; their investor relations platform that they can put their confidential material up and share it with investors who they want to give it to. They can put some public information up so people can find them -- non-confidential information -- so they can be discovered. Then they use it to communicate and collaborate with investors. That's the company.

On the other side, angel investors like me use Gust to find companies, to then collaborate with the entrepreneur, and to collaborate with others in an angel group or accelerators or funds, to pull together a financing round for the company.

Then, over time, because it's the infrastructure underlying this, is the communications collaboration platform, all the way through, for companies and their investors.

Byrnes: David Einhorn recently said that there may be a new tech bubble. As someone who's active in the tech space, what are your thoughts on that?

Rose: I don't think there's a bubble. What happened back in the great cataclysm of 2000, that was, nobody had heard of the Internet before. The Internet all of a sudden came in, was full of great promise.

Byrnes: Everything's new.

Rose: Which it was -- it was all new, and things got way out of hand. But as we saw in the last recession, which was a pretty bad recession, that had nothing to do with tech. Basically, everybody in the tech world during that last recession was looking around saying, "Hey, it's not us. We're in good shape. It's all those housing guys, and whatever."

Now, just the fact that you see a lot of stuff in the blogosphere about WhatsApp and Instagram and SnapChat and so on and so forth; those really aren't representative.

What is representative is technology now being applied to everything. We are now in a world of hyphen tech, of fashion-tech and ad-tech and food-tech. So, you're seeing the Internet and rapidly advancing technology being applied to every other business, and that's not going to stop. That's going to accelerate so, no, there's not a tech bubble right now.

Byrnes: I think a lot of traditional value investors will say, "We don't know how to value these companies," especially recent IPOs. We talked about valuation earlier. How do you look at that?

Obviously, these are much more mature companies, since they're coming public, but how do you look at that, when someone says, "Well, we have no earnings to base this on, we have very few sales to base this on" -- is it a similar problem to how you look at it with the angel investing?

Rose: You mean the bigger public companies? No, it's a little different because when you're talking about as start-up, there is really nothing -- or very little -- there. You're all betting on the comps.

Typically, angels come in at a stage early enough where they're still trying to find product market. We'd love to have that bit done before we come in, but often we'll invest before that, so they're pivoting their business models.

You're not going to see, in most cases, a big megacompany pivot their entire business model. Now, companies like Amazon can, over time, go from logistics and hardcover books to physical delivery of digital orders, to digital delivery of digital orders, to back-end web services and the like. But those are growths of the business.

In the early-stage world, businesses are totally pivoting, so once a company gets to the stage where investors and the market actually have public stocks in there, then it's a different story.

Byrnes: You're not buying the fact that these companies are impossible to value, these recent IPOs that are not making much money?

Rose: They're certainly more difficult to value than a traditional company where you have legitimate metrics and you can project it going forward. But again, for these early stage companies, you're still looking at growth.

People today who are buying the LinkedIns of the world, and the Facebooks of the world, are doing it not so much on day-to-day performance, as they are still buying the promise of future growth. We are only buying the promise of future growth, when it comes to the early-stage world.

Byrnes: It seems like recently there's been an uptick in acquisitions by companies, and letting them run as independent entities -- Facebook/WhatsApp, even five years or so ago, Amazon/Zappos, another example.

Is this a good thing for start-ups, do you think, and do you think that will spur more acquisitions because the founder can still be in charge there, and still have their own people, and run independently?

Rose: That actually is not the biggest single determinator of this stuff. Whether you are running your own company or not, it's a question of the larger issue -- is the company going to succeed, and is the company going to grow?

What you're seeing is, once a company gets to a big size... when you're a publicly traded company, it is very hard to change the whole ship of state. You can't move it around the way you can a start-up, so it's very difficult for a company with all this technology in play to continue to grow at these double-digit numbers all the time, and enter new businesses.

It used to be in the 20th century you could create Bell Labs or Xerox PARC or something, and put a lot of bright people say, "Go, invent the next new whatever-it-is." The world's moving too fast now; you can't do that.

Therefore, companies either have to figure out how to extend their core business models, like Amazon or Apple, who are the role models for all this, or else a company has to buy in this innovation. That's why you're seeing all these acquisitions.

Byrnes: We have a lot of investors watching right now, that are investors in tech companies, etc. What are some tech companies that you admire, and maybe ones that you like to see start-ups acquired by, if you're on that end of the spectrum?

Rose: As I said, if you take a look at the companies that aren't the flash in the pan companies, but are building real platforms where they enable growth of an industry, they enable growth of other companies, and they over time will get better and better as more people use them...

Things like Amazon -- what Jeff Bezos has done is really remarkable -- that is the poster child for how you envision what's coming next, and next, and next, and change your own core business.

It took Amazon 15 years to get to the dominant level of hard cover book shipments, and then they put out the Kindle and it only took them four years to beat their book shipments of paperbacks and hard covers combined, with digital books, effectively killing that business. Now, with the web services, they're enabling others to do online stuff.

You look at Apple, which has managed to transition over time from hardware to software to services. You look at LinkedIn, which is a company that is growing stronger and stronger and stronger with the more people who tie in.

I look for businesses that have network effects and a long-term place in the economy.

Byrnes: David Rose, thank you so much for your time. If you're at all interested in angel investing, absolutely grab a copy of this book. Thanks for coming down.

Rose: My pleasure, thank you.

Byrnes: Thank you.

Brendan Byrnes owns shares of Apple. The Motley Fool recommends and owns shares of, Apple, Facebook, and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.